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Trading Using Leverage

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What is Leverage?

Most amateur traders (buy and hold traders, etc.) trade using cash, meaning that if they want to buy $10,000 worth of stock, they must have $10,000 in cash in their trading account. Professional traders trade using leverage, meaning that if they want to buy $10,000 worth of stock, they only need $3,000 (approximately) in cash in their trading account (i.e. they only need a small percentage of the amount that they want to trade).

Trading using leverage is trading on credit, by depositing a small amount of cash, and then borrowing a larger amount of cash. For example, a trade on the EUR futures market has a contract value of $125,000 (i.e. the minimum amount that can be traded is $125,000), but using leverage, the same trade can be made with only $6,000 (approximately) in cash. Leverage is related to margin, in that margin is the minimum amount of cash that you must have in order to be allowed to trade using leverage. In the above example, the $6,000 is the margin requirement that is set by the exchange for the EUR futures market, and the remaining $119,000 ($125,000 - $6,000) is the leveraged amount.

Leverage Warnings

Non traders (and many amateur traders) believe that trading using leverage is dangerous, and is a quick way to lose more money than they started with. This is primarily because of the various warnings that are given regarding trading using leverage. Leverage warnings are given by financial agencies (such as the US SEC), and by brokerages that offer trading using leverage, and usually use wording similar to the following:

Trading using leverage carries a high degree of risk to your capital, and it is possible to lose more than your initial investment. Only speculate with money you can afford to lose.

With warnings like this, it is no wonder that many people consider trading using leverage to be dangerous. However, as is usual with government warnings, this is only half of the story, and very little of the truth.

Leverage is an Efficient Use of Capital

The reality is that professional traders trade using leverage every day because it is an efficient use of their capital. There are many advantages to trading using leverage, but there are no disadvantages whatsoever. Trading using leverage allows traders to trade markets that would otherwise be unavailable. Leverage also allows traders to trade more contracts (or shares, or forex lots, etc.) than they would otherwise be able to afford. However, the one thing that trading using leverage does not do, is increase the risk of a trade. There is no more risk when trading using leverage, than there is when trading using cash.

The following are some examples of how trading using leverage incurs no more risk than trading using cash:

Stock Trade

  • Symbol: XYZ
  • Trade: Long 1000 shares
  • Tick Value: $10 per 0.01 change in price
  • Entry Price: $125.50
  • Target: $126
  • Stop Loss: $125.25

If the above trade is traded using cash, the trader would need $125,500 in cash in order to enter the trade. If the trade was profitable (i.e. it reached its target), they would make a profit of 50 ticks, and receive $500 (50 ticks x $10 per tick) in profit. If the trade was not profitable (i.e. it reached its stop loss), they would lose 25 ticks, thereby losing $250 (25 ticks x $10 per tick) of their original capital.

If the same trade is traded using leverage, the trader would only need $37,650 in cash in order to enter the trade. If the trade was profitable (i.e. it reached its target), they would make the same profit of 50 ticks, and still receive $500 (50 ticks x $10 per tick) in profit. If the trade was not profitable (i.e. it reached its stop loss), they would still only lose 25 ticks, thereby losing the same $250 (25 ticks x $10 per tick) of their original capital.

The profit / loss outcome of the trade is identical regardless of whether the trade is made using cash or leverage, because the number of shares traded is the same (1000 shares in the example).

Futures Trade

  • Symbol: EUR
  • Trade: Long 1 contract
  • Tick Value: $12.50 per 0.0001 change in price
  • Entry Price: $1.2800
  • Target: $1.2900
  • Stop Loss: $1.2780

If this trade is traded using cash, the trader would need $125,000 in cash in order to enter the trade (because this is the value of the contract). If the trade was profitable (i.e. it reached its target), they would make a profit of 100 ticks, and receive $1,250 (100 ticks x $12.50 per tick) in profit. If the trade was not profitable (i.e. it reached its stop loss), they would lose 20 ticks, thereby losing $250 (20 ticks x $12.50 per tick) of their original capital.

If the same trade is traded using leverage, the trader would only need approximately $6,000 in cash in order to enter the trade (the margin requirement for the EUR). If the trade was profitable (i.e. it reached its target), they would make the same profit of 100 ticks, and still receive $1,250 (100 ticks x $12.50 per tick) in profit. If the trade was not profitable (i.e. it reached its stop loss), they would still only lose 20 ticks, thereby losing the same $250 (20 ticks x $12.50 per tick) of their original capital.

The profit / loss outcome of the trade is identical regardless of whether the trade is made using cash or leverage, because the tick value is the same ($12.50 per tick for the EUR futures market).

Conclusion

Trading using leverage is an efficient use of trading capital, that is no more risky than trading using cash (and can actually reduce risk, but that is another article). As a result, professional traders trade using leverage for every trade that they make. So, if you are still trading a cash account, either modify your account or open a new leverage (or margin) account, and start trading using leverage.

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